Episode #11 – Money Myth #2: Why Past Performance Doesn’t Predict Future Returns

Welcome to the Millennial Money Moves Podcast. In today’s episode, we’re busting money myth number two, track record investing. The idea that recent performance should drive your investment decision.
It’s easy to fall into the trap of hindsight bias, whether you’re an individual investor or a financial professional, but the data tells a different story. What’s hot today rarely stays that way for long.
And so putting too much of your money into one single thing that’s done really well lately has proven to not work for investors’ long term solutions. We hope you get some good tidbits out of this episode and really appreciate you for listening.
This content is purely educational and does not tend to be financial advice or financial planning. Please consult your professional financial advisor or tax professional to receive tailored advice to your personal situation.
Babin Wealth Management is not responsible for action taken by listeners based on educational content provided. If you would like to receive personal financial advice, please reach out to Babin Wealth Management directly at babinwealth.com.
Let’s make moves. Welcome, everybody, to another episode of the Millennial Money Moves Podcast. I am your host, Sean Babin.
We’ve got Blake Bandani, the co-host, back with us this week. Good to see you, man. I missed you last time.
Yeah, I missed you too, but you got to say it.
The one and only. We’re back.
Yeah, I think I’m going to laugh every single time you say that. I don’t know why. I know it’s coming, too.
You know it’s coming.
But yeah, good to be back in recording and, you know, getting back on the Millennial Money Moves Podcast took last week off.
And yeah, I’m excited to jump in to today’s topic. We do have Kenny Gatliff back with us again. Oh yeah.
And we’re going to just spell another Money Myth. The gold episode was great. Got a lot of good feedback, a lot of good hits.
And I thought that, you know, we’ve got a handful of Money Myths we’re going to talk about. So today we’re going to dive into Money Myth number two, which is what we call track record investing.
We’re using recent performance to make your investment decisions with all kinds of different assets. So that’s what we’re going to talk about today and dive into, you know, should you use recent performance?
And when we mean recent, I mean, we’re talking in the last year, two, three, four, five, even 10 years. Is that a good way to put together an investment philosophy or theme and put your money into things that have done well recently?
And yeah, that’s kind of where we’re going to head today. Anything from either of you before we kind of jump into it?
Looking forward to it. I think this is the one that’s probably the most prominently believed and for good reason.
So I think this would be a good one to kind of peel back that onion and see where there’s some truth, but where there’s a lot of, as you said, myth involved and how to distinguish between the difference. So looking forward to this one.
And I was going to throw a curveball, Sean, but I’ll just kind of give you a precursor. I’m just curious on the side of, well, you should still kind of use that if you’re going to make some investment decisions now. So I’d love to get into that.
That’s definitely one thing we’ll talk about where it’s like, you know, at what point is using hindsight, you know, worth your time using, using hindsight to develop a theme or an investment philosophy.
Obviously we’re all going to look backwards to some extent to see how these things have done in regards to different asset classes, different investments.
But when we talk about track record investing, typically most investors look at how it’s done in the last year, two, three, four, five, and they will put their money into something that’s really just done well in the last maybe half decade or even a
decade. And we’ve got some good data to show you that what has performed well recently doesn’t typically last.
And the reason you hear these things, like when we talked about gold, the reason why everyone’s talking about it now is because it’s up 40% in the last year.
And so when it starts hitting headlines, same with like Tesla, same with Nvidia, when it starts making headlines and people are getting those FOMO moments of like, oh my gosh, like, well, maybe this thing will go up another 40%.
Let’s put up my, like, we should put more money into it. We need to put some money into it. It’s typically the wrong time.
They’ve, that bubble has come and gone and they’re picking it up at the top. So that’s kind of what we talk about. Track record investing is using that recent historical performance to make your investment decision.
So in my world, where that really comes into hand, it’s kind of many different facets. The first and foremost, I think, is people from K’s. In a 401K, you typically don’t get many investment options, maybe 15, maybe 20.
And a lot of K participants, when they’re signing up, they’ll filter by what has done the best recently. And typically, it’ll show you a one-year return, a five-year return, a 10-year return.
And sometimes, it will typically tell you like a since inception, which is the beginning of that fund and with the date there. And I think most people just go to the five-year, sometimes the 10-year, and they’ll just filter by what’s done the best.
And then they just put all their money into it, not knowing really anything about that fund or what they’re putting their money into. They just want to see, okay, hey, if this thing’s averaged 15% a year for the last five years, that’s amazing.
Like, I want a piece of that. And again, it’s all hindsight. It’s all backward-looking.
There’s a well-known piece on every piece of our literature. It’s past performance is no guarantee of future results. So they’re all using past performance to make up kind of their investment philosophy in that moment.
So that’s kind of where I see it a lot is people kind of picking investments on their own or in those 401k moments. Another section that I want to get to at some point, I’m going to let Kenny kind of dive in here first is Morningstar ratings.
I want to talk about Morningstar because I think a lot of people, I’m going to say a lot, but the majority of people know about morningstar.com.
You can do a lot of free, easy fund research about different mutual funds, ETF, stocks, whatever the case might be. And Morningstar gives up to one to five star ratings on different funds.
And I want to talk about that rating system and how skewed it is and how backwards looking it is.
And I think a lot of clients and investors think, well, if I just buy a bunch of five star mutual funds, investment vehicles, they’re doing what they’re supposed to be doing.
But typically, again, that’s after the case, after those funds have done well, and they’re not likely, when I’ll show you the data, that they’ll continue to do well. So that’s kind of how I see it in my day to day.
Kenny, when you’re talking to other advisors or even some big clients that come your guys’ way, where does kind of this track record investing show up in your day to day with them?
Yeah, and as I open the show with, I think this is probably the most prominent thing that we need to educate against. And I think it can present itself really in three different ways, probably more than that, but three primary ways that I see.
One is on individual security, as you mentioned, your Tesla and Nvidia. The second will be kind of on asset class.
So, you know, US versus international, small stocks versus large stocks, growth, stocks versus value, you know, these different ways of parsing out the market. You know, the ones that have done well recently oftentimes come to the forefront.
And then the last one would be separate from that, but same idea, and that would be someone, you know, looking at an investment manager. And so this would kind of pair into the conversation about Morningstar rankings.
But you look at, you know, whether, you know, any of these big wirehouses or brokers, they’re going to have their different mutual funds, their ETFs. They’re going to, one, get their Morningstar rating.
So they’re going to have that to kind of hang their hat on. And two, they’re going to have those returns.
And, you know, that there’s a lot to unwrap regarding looking at returns from different funds, different fund managers, you know, what we can take away that’s useful and what we, you know, are kind of blind to, you know, relative to what’s happening
behind the scenes. So I’m sure we’ll get into that. But those are the three primary conversations that I usually end up having, you know, in regards to track record investing.
Let’s start with just an easy one, just kind of like asset classes and kind of chasing performance. I think I saw everywhere I went in all the different firms and even all the client statements that I got in the last 10 years.
As these technology companies have done so well, or what they called the FAANG stocks, Facebook, Amazon, Netflix, Google, they had all, you know, that section of stocks, the technology once had done so well, they’ve greatly outpaced the S&P 500 or,
you know, the NASDAQ, the QQQs that Blake has brought up in the prior episodes, you know, those lovely NCAA commercials that you see a ton of. They have done amazing in the last decade.
And so what I started noticing is advisors doing that performance creep where they just start putting all their clients’ money slow, more, every year that that continued to do well, they would continue to put more of their clients’ money into it
until I got statements that 90% of these clients’ accounts were in large cap growth names. You know, they’d have five or six different mutual funds, but they’d all be doing the exact same thing.
And so now they’ve gone from potentially, maybe they at one point had a diversified portfolio, but as that diversification underperforms the market and that track record of growth is doing well, growth does well again.
Oh my God, it’s continuing to do well. And they just slowly move more and more money each year, if their client’s money into more growth focuses, because it’s done well.
And it’s always again, that hindsight, like there’s no philosophy at that point, other than let’s just put more money into what’s done well.
That’s kind of the style creep that I see a lot of times from, you know, looking at client’s portfolios, and then we’ll get into kind of having a year like this year or a year like 2022, where that just gets, you know, decimated and they’ve gone
Yeah.
So I think that’s a good place to start, because certainly, as you mentioned, that’s on the forefront of people’s mind. And it’s always an interesting conversation to have.
And the way I usually present this is kind of taking a different direction to start and asking people, well, okay, do you want a diversified portfolio? Does that sound like something that’d be good?
And almost everyone to a person says, well, of course I do, I want diversification. Everyone knows that that’s a good thing in investing.
But here it ends up coming up to this concept called cognitive dissonance, which I think some people have heard of. And what that means is you believe something to be true, but you act as if it’s not. And that’s what cognitive dissonance is.
And so in this case, we see that presented in big pulled colors here where people believe diversification is a good thing. They believe that to be true.
But then when you show them, okay, well, here’s a bunch of different asset classes that don’t do the exact same thing. They say, well, I don’t want the bad ones. Well, that’s what diversification is, is getting things that move differently.
And if you get things that move differently, by definition, some are gonna be the winners and some are gonna be the losers. And what people will say is, yes, I want diversification.
And then they’ll look at all of the pieces of pie over the last five or 10 years and be like, no, I actually don’t want those ones that are doing bad. Just give me the good ones. So what they’re saying is they don’t want diversification.
They only want the winners. But then if you actually say that out loud, they say, well, of course, I can’t actually do that. That’s why I diversify.
So it’s really kind of breaking it down to this ideal inside their head as to what actually diversified investing is. And I think once you kind of outline that, a lot of people do have that light bulb moment of, okay, that does make sense.
But without that conversation, all they see is, look, asset class A is doing way better than asset class B over the last three, five, 10 years. Why would I possibly own B?
Exactly. It’s forever the hindsight bias. It’s forever, you know, 2020 vision from looking backwards and wanting to piece.
We all want to make more money. We all want a piece of what’s done well, and we want less of what hasn’t done well. But it showed me how many actual financial professionals didn’t have an investment theme and were more winging it than anything else.
And that was extremely scary because of how much they were willing to take on risk for their clients by continually stacking the boat with what had done well.
And how that works kind of at the bigger firms is, you know, these investment professionals or what we called product partners would come around and tout their best fund. Hey, you know, I have a fund that did 34% last year.
You should put your client’s money into it. And you’re like, oh, my God, like that’s a home run. That’s an incredible return.
Like, tell me, tell me more about that. And then you get another person that comes through. Well, my fund did 33%.
Okay. Well, that’s pretty good too. Like, let’s see that.
And then I would see time and time again, the diligence wasn’t done under what is in the fund. And those funds were pretty much exactly invested the exact same way. But they’ll be like, okay, this is a BlackRock one.
I’ll buy some of that. That’s a Vanguard one. Yeah, we’ll buy some of that.
And they’re the exact same things, but they think they’re diversifying because of the name diversification. Actually, what’s underneath is almost the exact same thing.
And so slowly, like I said, they would be moving their clients’ money into more and more concentrated positions each year because that’s what has done well for me lately. Well, that has, so let’s put more money into it.
Blake, have you personally, do you kind of understand this whole track record and kind of hindsight bias that we’re kind of talking about? And then how has it showed up kind of in your life that you’ve seen?
Totally makes sense. I got to put the hand up here. Being on the record-keeping side of these K plans or what we call the Custodian.
First-hand experience, I mean, I’ll be honest with you. I think Ks specifically, they lean on the concept of this isn’t… You’re not chasing short-term gains.
You’re chasing the long run, right? It’s not a sprint. It’s a marathon.
But I got to laugh inside my own head here listening to you guys because I’d sell some 401K plans for businesses. I’d work with the advisor on the plan and I’d ask him, hey, what do you want to do for the investment menu?
And they say, you know, I’m indifferent. I’m not too worried about it. I say, okay.
So what would I do? You’re going to like this, Sean. I’d get all the available funds.
I’d put it into Excel and then I categorize by Morningstar rating and 10 year performance. And I’d select based off of their 10 year return and are they four or five star on Morningstar?
And kid you not, most advisors would be like, that looks good, right?
Yeah.
Part of that would be because of the 401k aspect though, right? Like they’re, they know it’s a long-term play. I don’t think they’re too worried about the underlying investment.
So when you mention how you see a lot of these 401k accounts with individual clients, it’s predominantly because 401k plans do act exactly what we’re talking about, right? What’s the best 10-year numbers? What’s the middle expense ratios?
And are they four or five-star, Morningstar? And that’s what I would put the Excel sheet in and categorize it by. So it’s funny, man.
Would you notice that those funds were all very similar?
Yeah.
You know, they’re all large growth.
That’s what’s done well in the last decade. So again, reiterate what large growth is. Those have become the large technology, the Facebooks, the Amazons, the Microsofts, the Googles, the Netflix, the Teslas.
They are the ones who have dominated the marketplace in the last decade. And so what happens is, you know, people start thinking there’s some paradigm shift, like, okay, this is the new wave of the future. This is how it’s always going to be.
And they forego the investment philosophy, whether it was academics or just more diversified. And they’re just like, let’s just back up the Brink’s truck and put it all into these things.
And so when you run a filter like you did, or a screen of, hey, give me the best performance of the last 10 years in the four and five star mutual funds, or Morningstar ratings, you’re going to get all the same funds.
They might be from different companies, but they’re going to be doing the exact same thing.
But I think the average client, if you’re not using one of those target date funds, then the average client’s just putting 100% of their paychecks into an American fund’s large cap growth, again, all those technologies, that’s where all their money’s
going. They’re going to live or die by how that asset class goes.
Well, and in 401Ks, everything’s around fees, whether it’s the plan costs with the record keeper, whether it’s the underlying investment expenses. So like how much different is a blue chip with T-Row price versus JP Morgan, right?
But if T-Row’s five basis points less, let’s just go with T-Row, right? It’s funny.
It’s so funny and professional advisors will stack their clients accounts with T-Row, Franklin, American Funds, Fidelity, five different names that do exact same thing. And they call that diversification. And I saw it time and time again.
And when it continues to do well, again, I think the advisor just gets more confident in that, and then more money shifts. That’s again, that track record investing, where a logic kind of goes out the window.
Like Kenny said, you know you’re supposed to keep these clients diversified. You know we really shouldn’t be over, too over concentrated in one particular area.
But when that certain area has done well, and then it continues to do well, and continues to do well, you just start naturally wanting more and more of it. And it doesn’t matter. It could be large growth.
It could be anything. It could be international. Whatever the case may be, that creep happens.
And now that diversified portfolio goes to being very concentrated. And then when that area of the market corrects and goes down 22% like it did in 2022, then you’re screwed. And this year too.
I think it was down from the high, that large cap growth was down from mid February to early April. It was down 25%, 27%.
So Sean, and most people’s first experience with investments are their company’s retirement plan.
So if I am the novice investor, this is my first exposure to any type of investment vehicle, I think it’s only fair to assume I’m going to go in, check out the options that’s available, and look at who has the best 10-year score and just go with
that. But if you had done that this year, maybe the large cap wouldn’t have been your best, but the 10-year probably looks the strongest. So that’s why I think this is such an interesting topic.
Kenny, thoughts?
Yeah. So I think those of us in the industry can see through a little bit of this.
But I think the question that I would be asking if I was in the outside right now is, look, the three of you are telling me this isn’t the best way of doing it, but Morningstar is the biggest evaluator of funds on the planet, and they are giving
their star ratings. And some of these institutions you talk to have a trillion dollars or more flowing through, you know, under management. And this is what they’re recommending.
They have the smartest portfolio managers on Earth supposedly working for them. Like, why do the three of you know more than what they do?
It just kind of sounds like you’re just kind of sour apple or sour grapes here and saying, well, there’s a better way.
And so I think it’s really good to boil down as to if we’re saying this giant industry is all wrong, there has to be a reason, right? We’re not conspiracy theorists.
And so I think that’s really important, too, is to say, OK, you know, why are we saying that this is important?
And why are we saying that these giant institutions and every K plan out there, you know, are basically selling you on inefficient portfolios? And the reason is that most people don’t have…
We’ve been sitting here talking for, you know, 20, 30 minutes, and we’ve scratched the surface as to what diversification is, what a good fund is. Most people aren’t able to educate. And so therefore, they’ve got to use a lot of heuristics.
You know, OK, what’s a good rule of thumb for looking at account? Well, let’s just look at the star rating. Well, Morningstar knows that they can’t have their star ratings be terribly, you know, complicated or nuanced either.
So they are doing the same thing we’re doing. They’re saying, OK, well, how do I give my star ratings? I’ve actually read the perspectives of Morningstar.
Star ratings, how they work. There’s just a couple of factors. One is the 3, 5 and 10 year return.
Two is how closely they track whatever index that they’re supposed to track. And then third is kind of broken down between how big the fund is, the fund flows, and some other things that aren’t terribly, you know, well known or important.
But basically, it’s, OK, how good you are at tracking your index, which all that is telling you is how that index has done. And what your performance has been over the last 3, 5, and 10 years, which again goes back to which index you’re tracking.
And so when you spread that, you know, when you split all of this out, it comes back to everything is measuring the exact same thing.
If your fund looks like, you know, that whatever asset class has done well recently, your performance looks good, your Morningstar rating is good, your fund flows are going to be good, your AUM, your assets under management, is going to be good
because all those other things are good. So while it might look like there’s a lot of different factors that are being used, it’s strictly just that one. It’s all about performance of that asset class.
And so when you guys talked about, oh, you’ve got this T-Row, you’ve got this JPMorgan, Franklin, all of these different funds, well, they’re all being measured the exact same way.
They’ve got a portfolio manager who is picking a bunch of stocks to look very, very much like US large growth stocks. And when US large growth stocks have done well, all three of those look really good. They’re all getting five-star ratings.
They’re all getting money coming in to them. And they all become what’s listed in your investment choices in the 401k. Because again, Blake, to your point, we don’t have time to sit every 401k participant down and educate them onto the good strategy.
So it’s easy just to say, look, they’ve done well recently. They’ve got Morningstar, big service. They gave them five stars.
We’re giving you good options. Everyone can check the box. No one can get sued.
You’ve got your requirements. And it’s easy. And in that way, it’s not necessarily wrong.
It’s better than selling something that’s extraordinarily expensive or doing a poor job at tracking their index. So there are worse options out there. The key here is that there’s also better or more diversified.
And I think that’s kind of what we need to boil it down to, saying these funds aren’t bad. It’s just incomplete because it’s only going to give you what has done well recently, which might continue to do well or it might not.
And what we can reliably know from history is that something that has done well recently doesn’t always continue to be the winner. In fact, oftentimes, it’s the exact opposite.
You see these big cycles where whatever did well for 10 years then is the worst performer for the next 10 years.
And so that’s what we really, as investment professionals, trying to protect against is just using that limited option to getting yourself a very concentrated portfolio that may be the worst performer in the next 10 years.
And that is what we really, really want to avoid. And why we’re so adamant on having these conversations.
That was golden. That was perfectly said. That’s exactly what I wanted to get across to all the listeners.
It’s not the worst place in the world to start, but if you don’t have an understanding of what this can lead to, that’s the mistake. That’s the myth. The myth is buying recent performance to make up your long-term investment solution.
And that is the miss right there. You know, understanding the pieces of the pie that go into a successful investment journey versus let’s just continue to buy what has been well recently. So that was an awesome segue to some data that I have.
I’m going to share this because again, like Kenny said, anybody could be sitting here going, who the hell are these guys? What do they think they know? Like are they just talking about whatever they want, making stuff up?
Let’s actually show some numbers of what happens to the top funds that had done well recently and then how they perform over the next, you know, in this scenario is the next five years. So give me a second. I’ll pull this up.
So this is, you guys able to see the screen?
All right.
I need to blow this up.
Maybe zoom in a tad. Keep going. That’s good.
Perfect.
All right. So this is breaking down into equity funds and fixed income.
Equity stocks, those are kind of, again, when we talk about the growth drivers, fixed income are your bonds or that safety net, debt instruments that you kind of put the two together to create a diversified portfolio.
But we’ll just focus on the equity funds because the same thing rings true no matter what if we’re looking at fixed income or stocks. Is this study was done going back to 2004 through 2018 looking forward because it’s going forward five years.
What it did is it took the top 25, the top, you know, quartile 25 percent in the top 25 percent of stocks in that year. And then it said, how did they do the following five years? And where did they come out in the quartile rank?
So over here, we’ve got 100 percent. So if they would have stayed in the top 25, we would have expected them to be 75 percent and beyond.
And what you can see is in the stocks that did well from, you know, in 2000, 2001, 2002, 2003, they took those top 25 and then saw how they did from 2004 to 2003. Well, the average there, they ended up in the 28th percentile.
So they went from the top quartile to pretty much almost the bottom quartile. And this rings true in all these different five-year periods up through 2023, because that would be five years from this group, five years forward.
So Sean, the same underlying holdings tracking those five-year marks is what I saw, right?
Each year, they re-categorize what those top 25 percent would be. So this top 25 percent that was from 2000 to 2003 is going to be different than 2004 to 2008, if that makes sense.
And then they would see how did those top 25 percent do the preceding five years. I’m articulating this correctly, right? I know you’ve seen this graph before.
Yeah.
So I’ve presented this quite a few times, and this is one of my favorite charts, and inevitably most people have no idea what I’m talking about at the end of it.
That’s how I feel right now.
I’m trying to explain because you’re talking quartiles from one five-year period to the next. So I think it’s good to bring it back and apply it to the example we were just talking about.
So Blake, when you’re talking about, for my 401k fund, fund options, let’s just, since we have four quartiles, let’s just say we have four funds, and you say, okay, well, I’ll just pick the one that did the best, right?
And so in this case, you’ve got four different funds, one’s the best, one’s the worst, that makes four quartiles, right?
So what this is saying is, okay, I’m gonna look at what it did the last five years, and the one that did the best, I kind of expect that, although we have that disclaimer of past performance, that should give me some assumption that it’s gonna be a
better performer over the next five years as well. I expect some consistency with that performance.
But what it’s saying is, when you’re looking at that next five years, it has no statistically relevant or consistent expectation to finish in that next quartile the following year. In fact, those next four funds are just the roll of the dice.
Those numbers that you’re seeing next to, if you’re watching the video, 28%, 23%, 23%, that’s actually the number of the funds that were in the top quartile the following five years.
So, if you’re doing random chance, so if I’m just picking 100% random chance, rolling the dice, I expect 25% of them to be in the next quartile again, right? In the top four. So, what we see here is only 21% of them do.
So, the best fund managers, which again, this is going to be measured by five-year performance, which is the same thing as your Morningstar funds, they’re looking at performance.
So, you’ve got the top 25% of funds based on performance and based on Morningstar star rating, then you’re looking at what they did the next five years, and less than one in four of them repeated and made the top quartile again, meaning they did
worse than a random roll of the dice. So, what that tells us is there’s absolutely no correlation if a fund did well for the last five years that it’s going to do well for the next five years.
If there’s really good correlation, we expect that to be 100%. If there’s some type of correlation, saying they’re going to maybe do a little bit better than the rest of the managers, we expect that maybe to be at 50% or 75%.
A lot of those guys can repeat, if they did well the last five years, they’re going to do well the next five years too. A lot of those guys are going to repeat. What we found is that less than what would be expected by random chance end up repeating.
And that tells you everything you need to know about looking at the last five years of what something did or looking at that Morningstar rating as to what the expectations are going forward.
So if you understand this chart, you really don’t need anything else to explain this point.
So what’s the underlying theme though? Monitor that fund every year?
I think the underlying theme is to build a portfolio based on a philosophy, not based on one manager. Because as we were talking about before, the funds that did well in the previous five years, there’s going to be two factors.
One is whatever asset class that they’re in. If they’re a US large growth fund and US large growth did well, they’re going to be in the top quartile.
If they’re an international fund and international did well, then they’re going to be in the top quartile. It’s all about what they’re tracking and what their mandate is. The second is the fact that these aren’t risk adjusted returns.
So if someone made a big bet and won, congrats to them, they did very well. But all that I know from that is that they’re willing to make a big bet with my money. It means they’re taking on too much risk.
And that’s why we see honestly, a lot of these funds go from the very top to the very bottom. Because if you’re willing to take on risk and it hits one time, you’re just as likely to take on risk that next time period and have it not hit.
And so because these aren’t risk adjusted returns that you’re looking at, sometimes picking the absolute best performing funds, I would say those are as bad or as risky as the worst performing because it means they’re willing to take risk that I
And they’ve picked it after the fact.
That’s the whole notion of if you’re seeing these amazing numbers in a single stock in a commodity like gold or in some kind of crazy mutual fund that you found through research, it’s already happened. It’s done.
Like you’re seeing the data at that point that you’ve missed out on it. So it’s understanding, okay, is it worth? Like can this fund do 34% again next year?
Like obviously, it’s dictated by so many factors, but that’s that buy high moment or those FOMO moments that happen in the meme stocks, the crypto currencies, any investible commodity or asset out there. That’s how bubbles get formed.
It’s because money starts running into those things. And the later you are into the game.
And what I saw with advisors, again, stacking their clients’ assets in more and more concentrated areas that had done well over the last year or two years, like, hey, let’s just buy more of it.
They’re again, causing, adding fuel to the fire, putting more assets into something makes those prices go even higher. And that makes that peak even steeper for when inevitably it will correct at some point.
So that’s the thing is that notion of these fund managers or professionals that did well in the last five years can’t even consistently do well in the next five years.
Why are we rushing into some of these things that have just done well for us lately and foregoing kind of investment philosophy and an investment theme or solution?
Well, I think if you think about it, Sean, even from my point of view, virtually everything else in this world, if it’s consistent, you trust it. It just doesn’t apply to investments, which I think is a hard concept to grasp as a novice investor.
Right. But that’s the whole point of this podcast.
Yeah. It’s investing is an extremely tricky, tricky landscape with many snake oil salesmen out there, people who look to be professional.
I mean, what scares me the most about being a part of this industry and seeing professionals on the other side is like, people look at us like we’re doctors and like that scares me about, honestly, doctors of like, holy smokes, like how much of a
professional are there? What are their beliefs? What is their education? What is their foundation and their belief with their practice and with their patients and with their clients?
Because what I’ve seen on the finance side, scares the hell out of me for just professionals across many different places of practices of sorts or disciplines is kind of the word I’m looking for there.
Because again, you sit across the desk from a paid professional that has the credentials on the wall, they work for a big company, maybe they have their own, and you’re honestly at the end of the day, just hoping that they’re going to be that
fiduciary and do right by you. But you on that as the end client that doesn’t know enough to be dangerous in this space, sometimes you can get taken on rides without asking questions again, just kind of with that blind trust.
And that’s how I feel when I go to a doctor’s office. I don’t know what the hell I’m doing.
So when I sit there and they say, hey, you need this surgery or you need to get on this medication, you’re genuinely, you’re hoping that they’re being a fiduciary to you and hoping that they’re doing exactly what they would do for their own kids.
And so again, like I said, it creates some kind of weird uncomfortableness for me when I actually am with other professionals and they’re telling me what to do, because I’ve seen it done so wrong for so many people in this industry.
It’s got to be kind of consistent through others, just by random chance, I would imagine.
Well, how do you think I felt when I’d have advisors tell me, hey, just give me a good screen on what you think looks good. I’m like, sure.
Yeah, they don’t want to put the diligence behind it. Yeah, time is money, and they don’t want to put the diligence into it.
And like Kenny said, to avoid kind of problems or lawsuits, they can fall back on what we gave them, the best funds available, these five-star ratings, you know, the best performance, and there’s all kinds of stuff that goes out there.
All right, I got one more slide, because I, again, love the data behind this, that kind of shows kind of that bubble movement that I was talking about where, you know, things become bigger and bigger in regards to their stock movement, their price
movement, and how people kind of jump on to it, and then how inevitably kind of that bubble breaks. So this is basically chasing kind of the biggest stocks as they become big, and then what happens to them after they’re kind of the biggest in the
world, and how they perform kind of the following here. So let me share my screen here. And I’m sure Kenny’s seen this one too.
So I’m going to have him kind of run with this slide at the beginning, because you do such a great job of articulating all this fun stuff here. So this is again, it’s called Think Twice About Chasing the Biggest Stocks.
And it talks about 10 years before a stock becomes the biggest stock, kind of its average performance, then 5 years before it becomes one of the top 10 biggest stocks, 3 years before.
And then when it actually becomes one of the top 10 stocks in the world, or in the US, sorry, they’re talking US stock market, and then its performance the next 3, 5, and 10 years.
So this is again what we talked about, that concept of, great, they’ve made their money, they’re making their companies doing so well, the stock price is growing and growing and growing, their market cap, which is how many shares they have
outstanding times, the stock price is growing and growing and growing, they become that first trillion-dollar company and their performance is great. And then boom, they’re one of the biggest stocks or biggest companies in the world.
What happens to them after that? Kenny, you’ve seen this performance, right, as well?
Yes, definitely. And this is such a great one too, because this hits that kind of the third leg of that stool that we talked about, of different things that people can easily be deceived on.
So I think, again, it’s good to look at this from a practical standpoint of saying, okay, if a stock is one of the 10 largest in the S&P 500, meaning at this point becomes one of the biggest stocks in the world, how did they get there?
Well, obviously, it’s going to be because they did very well. So there’s some idea out there that says, if I want the best stocks, all I have to do is buy the biggest ones because that means they’ve done well. And it does mean that they’ve done well.
Earlier, Sean, you talked about the Feng stocks and the Mag-7 stocks and all these just giant US stocks that have driven the stock market of late. And those are all in the top 10 now.
And so I think what’s really important is to say, well, what’s important to me? Is it important to me what they’ve done in the past? Or is it important to have an expectation of what they’re going to do in the future?
And some people do think it’s the same thing. And they say, well, they’re obviously the best companies in the world if they’re this big. So surely, they’re going to continue to be profitable.
And surely, that means that they’re going to continue to return well. And obviously, what you see on this graph right here is this top 10 stocks, when they become the top 10, by definition, they did really well in the past.
And these returns, the outperformance returns, are phenomenal.
But once they become a top 10, once you’ve heard of them, you know, the NVIDIAs and the Teslas and the Netflix and Apples, you know, once they’re in that group, well, then what do they do in the future?
And that’s when, you know, these historical numbers saying, well, once they become one of the top 10 biggest stocks, there is no future outperformance, at least historically.
And in fact, after five and 10 years, they’re actually underperforming the market by almost 2%.
So, if you’re just blindly saying, okay, I don’t know anything about stocks, so I’m just going to buy the 10 biggest at the beginning of every year because of the logic that I just went over.
Well, that means that historically you’ve underperformed the market over the next five and 10 years. That’s really shocking to most people. I think most people would think, yeah, it’s definitely going to do pretty good.
At worst, it’s going to, you know, just keep up to pace with the market, but probably it’s going to be better. You know, those are all the names that I’ve heard of and that have done so well recently.
And so I think this is a surprising statistic for many, many people if you showed them that. And I think, again, when we’re looking at it from a practical standpoint, well, what does that mean?
You know, it’s easy to think that this time is different and that Tesla and Apple and, you know, these Mag 7 stocks are different than the top 10, you know, 10 years ago or 20 years ago, but it’s always something different.
There’s always some new technology that propels these stocks to be in the top 10 in the first place.
You know, it’s been AI and semiconductors and chips and, you know, a while back, it was internet stocks and software and all these other things that were the biggest technology at the time. And the story has, you know, been time and time again.
People think that this new technology is game changing and life changing, and therefore, these giant companies are going to rule the world forever and, you know, provide better than market rates or return forever.
And that just is not what we’ve seen historically, and it’s not what we should expect in the future.
I guess listening to you guys, because this is great, and this one is specifically what you’re showing. It’s powerful, right?
But how do you, as an investor, how do you decide, like, am I in that phase right now where it’s going to be the biggest, the baddest it ever will be?
Like, how do you, I’m not saying we have answers to it, but like, how can you, as an investor, be a little bit smarter to know this and decide, okay, maybe it’s time to start looking elsewhere, I guess, is what I’m seeing from it.
I think the answer to that is you don’t know. And that’s been the story we’re telling, you know, this whole time. That is why we diversify, right?
Like, I opened this entire show saying people love the idea of diversification. Why do they love that?
Well, because people don’t like the idea of being overly concentrated, having all of your eggs in one basket, because they know what can happen if they’re wrong, right? So if we knew, we would not want to be diversified.
We would want to put all our eggs in that basket if that basket is the winning basket. But the idea is that we don’t, and so we, okay, we’re going to own these stocks because we might only be on year 7 of a 10-year run, but we might be on year 10.
The fact that we don’t own that means, we don’t know that means we should own these, but we should also own some other stocks that represent different parts of the market.
Because you never know when you’re at the top of that bubble or when this run is going to end.
And what you don’t want to be left with is at the end of the 10 years, you thought you were buying these stocks that would do well forever, and you’ve underperformed the market by 1%, 2%, or more if you got unlucky on your timing.
As always, well said, Kenny.
For the listeners out there, I don’t think we articulated this graph well enough. It looks beautiful. But for the listeners out there, we have data in front of us going back to 1927.
And it’s showing that the average annualized return for the largest 10 companies in the US outperformed three years prior to joining the top 10.
So as they’re becoming bigger and bigger, and before they get to three years prior to becoming one of the top 10 biggest companies in the US, they outperform the market by an average of 25. And that’s why you start hearing about it.
And they’re doing something, they’re making something, they’re progressing the country, the world, technology, whatever case might be, to get to being one of those top 10 companies.
But then the data is showing once they become one of those top 10 companies in the US, that underperform the market by around 2% per year the following 5 and 10 years.
It’s not like they don’t make any money, but they go from those humongous outperformance that put them on the map to kind of becoming more part of the average Joe stocks.
So again, it’s highlighting the idea that if you’re just buying the top 10 stocks after these runs have kind of happened, you’re just going to get more or less market rates of return going forward.
And so that’s what we’re trying to accomplish for all of our clients too. But we’re doing that in a more diversified approach.
And that’s what I tell every one of my clients is, hey, you are never going to outperform the best asset class, but you’re never going to underperform. You’re never going to be down as much as the worst one either.
It’s not taking the full load of any single area of the market and just putting your flag in it and hoping, all right, this is what’s going to sail us through for the next decade or 20 years to get us to where we need to go.
It’s taking a more systematic approach to that.
The last thing I would want to say here is that I think people see these top 10 companies and they look at Apple’s and Microsoft and they say, look, there’s no way these companies are not going to be profitable over the next 10 years.
They’ve got giant market shares, someone even called monopolies on these different industries. These industries are not going away. Give me any good reason as to why Apple or Microsoft or any of these are not going to make money in the next 10 years.
And I think that’s where people don’t understand what the stock market is to some degree.
And companies’ ability to be profitable does not necessarily mean they’re going to give stock market returns, or they’re not necessarily going to give oversized stock market returns.
And there’s so many good examples of this, and this is why I don’t have the data right now. But it’s all about the valuation or the price of these companies.
And what we’ve seen, and Sean, you highlighted all these great returns leading up to this, is that investors have already priced up these companies extraordinarily high.
And so what they are saying now is, look, we already knew that Microsoft and Apple were going to be great companies. In fact, we priced their current price on the expectation of giant future profits.
That’s how a price is determined, is the future profits discounted back to today’s price. So however good you think a company is, that is what their current price is. It’s not this complicated formula.
It’s people saying, I think the best companies should be worth more now, because they’re going to be good in the future.
And so there’s so many examples of companies that were extraordinarily profitable for multiple years, yet their stocks made no money, because they got priced up just a little too high on the front end.
One of the great examples is, I don’t have this data in front of me, but maybe we’ll look it up for the next podcast.
McDonald’s in, I think it was the 70s or 80s, got priced up so high that even though they were the most profitable restaurant in the world for the next 20 years, their stock made no money. And another great one is Microsoft.
It’s been one of the biggest, best companies in the country for over 30 years now. Yet from 2000 through I think 2015, the stock made basically no money because it got priced too high.
It said nothing about how good the company was or would continue to be. It’s just the fact that people thought it might be just a little bit better and priced it a little too high.
So I know that was a little bit of a tangent, but I get that question a lot when people say, yeah, but look at these top 10 companies. They’re so good. And you can say, yes, I’m not saying they’re not going to be good.
I’m not saying that they’re going to get replaced by someone. They will almost definitely continue to be the best companies. That doesn’t mean they’re going to outperform.
Their stock prices are going to outperform in the future. So that is just one thing I just want to throw in at the end.
Yeah, because what happens is to get the kind of performance that they’re having, their company is absolutely crushing the current expectations that are out there.
And then when the expectations for their growth become so high, like NVIDIA went through this, like their earnings calls, if they didn’t have this like, I’m making up numbers at this point, but you know, for 300, 400% growth in certain areas of their
business, if they came up short by, you know, only did 280% growth, but they were supposed to be 300, based on the expectations, boom, stock price goes down. So what happens in these huge run ups to get to being in the top 10 is they’re crushing it.
They’re, you know, the computer, the Apple innovations and the iPhones and the watches and all this stuff. They’re like, oh my God, like look at what they’re doing. Look at how much they’re making.
Look how much people love these products and their stock gets repriced in expectation. Then those expectations become just like the norm.
Like, look, you’re gonna have to continue to absolutely dominate in a space that you’ve dominated for the last 10 years. How do you continue to keep coming up with that to get to where you, you know, what got you to where you’re at?
Like now they kind of chug along, and that’s what this chart I love is showing. It’s not showing you that these stocks lose money over the next 10 years.
It’s just they make about what the market makes versus continuing to blow it out the water because now the expectations for that company are very well known around the world and what they’re supposed to be doing, and their expectations are very much
priced in. And now there’s just more downward pressure than there is upward pressure. It’s very, very hard for them to continue to keep the pace of growth that got them into the top 10. All right, we’ve gone 50 minutes now.
I want to leave it with just a couple closing thoughts. You know, we’ve gone over a lot of what investors should consider before just buying something based purely on short-term performance.
So a couple of things I want to end with Kenny asking you is, what do you consider is enough data that you’re comfortable with to recommend something like hindsight, like looking backwards, are you comfortable looking back 10 years, five years, 20
years, 30 years, 50 years, 100 years to kind of come up with to using that data set comfortably for you to put into someone’s portfolio? And then what can we just take away from this and what should we use kind of going forward when considering about
Yeah, so it’s not an easy formula.
I would say that the idea of looking backwards and saying, okay, well, if past performance isn’t indicative, then how do I know what to invest in at all? And so it’s a combination of time plus the degree to which something overperformed.
So if it overperformed by a 10th of a percent, well, I don’t care about that. But if it’s significant over performance for a long time. But there also has to be, I guess, the third piece would has to be risk adjusted, right?
If the average return was 10 percent, but one stock went up 50 down 50 up 60 down 60, and another one was just 10, 10, 10, 10, 10. Well, that’s very different, too. And then the last piece is there has to be some story connected to it, right?
Why did something over perform for the last 5, 10, 20, whatever years?
And that story has to be rooted in the philosophy that we adhere to, that we understand that the market, both in stocks and in business economics, is going to be a very efficient, free market oriented environments.
Within that framework, if something has outperformed by a lot for a long time, and there’s a good reason why it has, well, then I can feel good that it’s going to continue to outperform in the future. A great example is just stocks over bonds, right?
Stocks have outperformed by, depending on the endpoints you look at, four to five percent over just a risk-free bond for as long as we have history. Why is that? Well, they’re a lot more risky, right?
Like stocks can go up and down, whereas bonds, generally, you have that guaranteed stream of income. So that’s a big piece of it.
And you’re taking advantage of the growth of these companies, of your Apples and Microsos and all that, whereas bonds are just saying, yep, I’m just going to pay you three, four, whatever percent, you know, until the maturity happens.
So, you know, there’s a story as to why stocks should make more than bonds. They have forever. So, that’s a reliable thing.
And so, I think, you know, running it through each of those different filters, I think is really important. And then I forget the second part of your question, Sean. I think I answered the first part.
That was perfect on the first part.
Yeah, just kind of, we’ll just leave it with some best practices. You know, I keep thinking of the person who is just kind of doing this on their own. They get handed the FNKA packet.
They’re looking at the 10, 15 different options. You know, if they could take away something from this, of like not just filtering by what’s done the best in the last 10 years, what are some best practices for people getting started?
Yeah, I would say look at the asset classes represented, because that’s a much bigger deal than the name of the fund itself, you know, whether it be the company behind it or what they’re calling themselves.
And so if you have US large stocks, also get some US small stocks, also get some international stocks and then find someone that is a professional that you trust, that has your best interest in mind.
And we preach on that a lot, but if someone is out there selling a certain kind of fund, well, that’s like asking a Toyota salesperson what the best car to buy is, right? They’re going to tell you Toyota. And that doesn’t mean they’re wrong.
It just means they’re not, you know, they’re going to be biased toward their own.
So someone who’s independent, who isn’t getting commissions for selling one specific product or one specific fund class, and probably someone that knows what they’re talking about.
You know, Sean, you mentioned, you know, that the idea that we look at the financial professionals, we get a little worried.
Yeah, you know, you can graduate from high school or go to community college and then pass one test and call yourself a financial professional. I’m not saying that’s what most people do, but it is possible to do that.
And if you’re a good salesman and you’re good with people, you can even be successful doing it. So look at what that person’s credentials are and, you know, have a conversation with what their investment philosophy is.
What, you know, does their philosophy stand the test of time? Or are they just picking, you know, the stocks with the best 10-year track records or Five Star, Morningstar rating?
So I think that’s where, you know, finding someone who’s credentialed that, you know, knows what they’re talking about, that has a philosophy that they adhere to and will stand by, I think is really important as if you are looking to get advice.
Yeah. And one that they can articulate to you and one that they don’t say, well, this is what’s done really well for us the last 10 years.
You’d be surprised how often people in just very, very high up positions will say that exact thing, Sean. It’s like the same thing I did when I was 22 years old, looking at my first 401k statement.
And this is what you, as the manager of some giant firm on Wall Street, is telling me, yeah, this was done pretty well for us. And it’s like, there’s nothing different between those two people other than the salary.
Yeah, exactly. I was just going to say that the amount of money that they make and what’s on the table. So awesome conversation, guys.
Money myth number two, track record investing or hindsight bias dispelled here. So thank you guys for joining me. We’ll get working on number three next month.
And yeah, we’re looking forward to seeing you next week, Blake. And yeah, appreciate you guys’ time. Appreciate you guys.
Sounds good.
Thanks, Sean. And Blake.